Skullcandy has a Strong Quarter

Income from operations rose, but as a percentage of revenue it fell from 25% to 18.3%.

 

Skull is dependent on two Chinese manufacturers for their product. Like everybody else, they are experiencing higher costs from China and note that their gross margin might decline if they can’t pass these costs on to consumers.     

 

Remember that this quarter closed before they went public. As a result, we have $1.9 million in related party interest expense that wouldn’t be there if the offering had closed during the quarter. Also, I’m not going to spend any time on the balance sheet as it improved dramatically after the IPO. A bunch of cash has that impact on a balance sheet.

 

Just one balance sheet comment. Inventories grew 86% from $22.6 to $41.9 million. They discuss this in the conference call. Part of the growth was due to inventory levels being too low last year, and part is because of the acquisition of Astro Gaming. They also decided to increase their stock levels in 2011 to better service their retailers.

 

In discussing their outstanding orders, Skull says, “We typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped….As of June 30, 2011, our order backlog was $10.1 million, compared to $10.0 million as June 30, 2010. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain.”

 

Obviously, they can’t wait for orders from retailers before placing orders with their factories. They say in the conference call inventory growth was roughly in line with sales if you ignore those three factors. But it looks to me like some of the inventory increase results, as Skull puts it, from “…pressure on our supply chain” that’s requiring some inventory growth in excess of sales growth.

 

Okay, one more balance sheet comment. There was a statement on the call about how, because they carried their inventory under FIFO, product margins had benefitted so far this year. In the second half of the year, as they start to sell the higher cost product, that benefit will go away. This inventory accounting stuff is going to start to matter with costs rising. I wrote about it in a bit more detail when I took my last look at VF Corporation.

 

The company’s net proceeds from the public offering in July were $77.5 million. Of that amount, $43.5 million, or 56.1% of the net proceeds, went right back out the door to pay accrued interest on convertible notes, unsecured subordinated promissory notes to existing shareholders, notes in connection with already accrued management incentive bonuses, and a bunch of other moneys due to existing stockholders. They used an additional $8.6 million to pay down their asset based line of credit in early August, and they may use a portion of the proceeds to buy back their European distribution rights. If that happened, that would leave them with $10.4 million of the offering proceeds, but they continue to have availability under their line of credit. 

 

If I had all the time in the world I’d like to go review and understand in detail how Skull financed its growth. It’s always hard to finance fast growth and it got harder when the economy went south. It must have been an interesting experience. Ah well, what doesn’t kill you makes you stronger.

 

In the conference call Skull management laid out its five major strategies. The first was to further penetrate the domestic retail channel. Skull is currently in Best Buy, Target, Dick’s and AT&T wireless. Domestic sales were about 80% of the total. During the quarter net sales to three customers totaled 27.4% of total sales and represented 44.4% of receivables at the end of the quarter.   That’s down from 33.2% of total sales and 46.9% of receivables at the end of the same quarter the previous year.

 

The second was to accelerate its international business, which is largely in Canada and Europe. It grew by 47.1% in the quarter and represented about 20% of total sales. A dispute with their European distributor had reduced 2010 sales, so part of the growth is catching up.

 

They sell in 70 countries and have 26 independent distributors. They want to distribute directly in key markets. This is a strategy most other companies in our industry have utilized.

 

57 North, their European distributor, represented more than 10% of their sales during the first half of 2011. In June, Skull entered into a non-binding letter of intent to buy those distribution rights back from 57 North for $15 million. As noted above, Skull has had a previous dispute with 57 North, and from the way they describe it in the 10Q, it sounds like there’s some uncertainty the deal will close. Maybe that’s just what they have to say because it’s a non-binding letter and negotiations are still ongoing. 

 

The third strategy is to expand their premium priced product category. The “vast majority” of their products are priced in the $20 to $70 range. They said they had premium products in the pipeline that could be released in the next 24 months. I’m pretty sure they said “could,” so unless they just used the wrong word, there seems to be some doubt as to the timing.

 

One of their existing premium products is the Aviator. They launched it in Apple stores and it was exclusively available there for six month. I like that distribution strategy but of course it may cost you some sales early on.

 

A fourth strategy is to expand complimentary product categories. This includes Astro Gaming’s head phones. They bought the company in April for $10.8 million. Astro sales are obviously included in the June 30 quarter. I don’t know exactly how much those sales were.

The fifth strategy is to increase online sales. Those sales were $4.3 million in the quarter, or 8.4% of net sales. In the quarter last year, online sales were 3.9% of total sales. $2.5 million was organic growth, which tells us that $1.8 million in online sales came from the Astro Gaming product. Organic online growth was 117% over the same quarter last year.

 

These are all fine strategies. In fact, they are so good that most companies are trying to implement them. What Skull says they have done is, “…revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music.” I think they are right, but we’ll have to keep watching to see if they can continue to do it better than anybody else.